MKC: Not Much to Love About Spices

Quick-hit update: still not much to like about MKC

Today’s Q3 2013 release was very much an extension of last quarter’s call:

The quarter did arrest the last 5 straight quarters of revenue declines with sales growing at +4%, versus +1.9% last quarter, but 3% of it was driven by its acquisition of Wuhan Asia Pacific Condiments (WAPC) in May 2013

The company expects to deliver +7% sales and eps next quarter, which we think is a stretch (despite an easier Hurricane Sandy comp)

We expect the weakness that management cited in quick service restaurants (QSR) and geographically in China and USA, and a lagging industrial business to continue into year-end despite slight offsets as we move into a heavier buying season around the holidays and an increased $10MM marketing spend

Our macro call is that Bernanke is pulling the confidence cord in issuing his “no taper” call which we expect will translate to subdued confidence into year end. With Europe seeing only slight improvement off of low levels, China still at depressed levels (compared to recent year comps) and slowing, and Latin America (mostly Mexico for MKC) a mixed picture, we’re not comfortable that the macro will be playing at MKC’s back

Also, spice consumers remain very sensitive to price and typically purchase last minute: the company has not taken up price (or perhaps been willing to) in 2 years. It is planning to implement a 3 cent price increase next quarter – we’ll have to see how the consumer reacts

The stock has underperformed its peer group over recent months, and we don’t expect this trend to inflect. We’ll let the chart below of our levels on MKC do the talking: it is bearish over its immediate term TREND:

Matt Hedrick

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09/26/13 12:27 PM EDT

INITIAL CLAIMS: REMEMBER APRIL 1999 OR JAN 2006? THAT'S WHERE CLAIMS ARE TODAY

Takeaway:Strong claims data will beget strong NFP numbers between now and year end. We remain bullish on the consumer lenders: COF & BAC.

Should We Care about the Tail or the Dog?

We would make two points with respect to this morning's labor market data.

First, the data is exceptionally strong. For perspective, SA rolling initial jobless claims are now at levels last seen in April 1999 and January 2006. Recollect the market environment in both those periods. Consider the chart below.

Second, since the market seems obsessed with the NFP report that will come out next Friday, here are a couple thoughts on how claims do/don't relate to NFP.

a) The first chart below looks at the time series data back to the start of 1999. Rolling initial claims are in red on the left axis while private payrolls are in blue on the right axis and are inverted to make the relationship more apparent visually. We think that the visual makes it quite obvious that there is a relationship between these two series.

b) The second chart below shows the same data but on a scatterplot. The RSQ is somewhat low at 0.528, but nevertheless the relationship is still quite clear, we think. The blue series is monthly data from 1999 to Present, whiel the green box is the most recent data for August 2013. Just by coincidence, the most recent data pair was almost exactly on the pin of the regression line. This month's claims data, for reference, would suggest private payrolls of 195k for September, by the way. Unfortunately, the standard error is significant. It is too large to have much conviction in the accuracy of the estimate.

c) The final point worth making is that these two data series are cointegrated. The best definition I could find online for cointegration is the following: "The old man and the dog are joined by one of those leashes that has the cord rolled up inside the handle on a spring. Individually, the dog and the man are each on a random walk. They cannot wander too far from one another because of the leash. We say that the random processes describing their paths are cointegrated." - Link. We ran an ADF test (augmented dickey fuller) to see whether claims and NFP are, in fact, cointegrated and the p-value was 0.038. In other words, there is a 3.8% chance they are not cointegrated, and a 96.2% they are. Cointegration matters because it means that as claims go, eventually private NFP will go, just as the man with the leash will ultimately determine where the dog on the leash ends up.

The Data

Prior to revision, initial jobless claims fell 4k to 305k from 309k WoW, as the prior week's number was revised up by 1k to 310k.

The headline (unrevised) number shows claims were lower by 5k WoW. Meanwhile, the 4-week rolling average of seasonally-adjusted claims fell -6.75k WoW to 308k.

The 4-week rolling average of NSA claims, which we consider a more accurate representation of the underlying labor market trend, was -17.6% lower YoY, which is a sequential improvement versus the previous week's YoY change of -16.2%

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ICI Fund Flow Survey - Continued Weakness in Munis...BEN has the Most Exposure

Takeaway:The trend of smaller bond fund outflows continued in the most recent week but still both taxable and tax-free bond funds booked outflows

Investment Company Institute Mutual Fund Data and ETF Money Flow:

Equity mutual fund inflow decelerated week-to-week to $3.4 billion for the 5 day period ending September 18th, down from the $5.2 billion inflow the week prior but remained well above last year's weekly average

Fixed income mutual fund outflows improved sequentially W-o-W but still resulted in a $2.6 billion withdrawal by investors, an improvement from the $6.7 billion draw down last week

Within ETFs, passive equity products experienced the largest weekly inflow in at least 2 years, with $25.8 billion coming into the equity category. Bond ETFs also had positive trends, although on a much smaller scale, with an $850 million inflow in the most recent weekly period

For the week ending September 18th, the Investment Company Institute reported a deceleration in equity fund flow trends although with fund flow still positive for stocks and an improvement in fixed income mutual fund flows, however with bond trends simply booking a smaller outflow. Total equity fund flow totaled a $3.4 billion inflow which broke out to a $3.3 billion inflow into international equity products and a $44 million inflow in domestic stock funds. These trends decelerated from the prior week's total equity fund inflow of $5.2 billion. Despite this slow down in stock fund flows, the year-to-date weekly average for 2013 now sits at a $2.6 billion inflow for total equity mutual funds, a substantial improvement from the $3.0 billion outflow averaged per week in 2012.

On the fixed income side, outflow trends continued for the week ending September 18th with the aggregate of taxable and tax-free bond funds combining to lose $2.6 billion in fund flow. The taxable bond category specifically shed nearly $900 million, the smallest weekly outflow in 6 weeks and a vast improvement from the $2.8 billion loss last week. Tax-free or municipal bonds continued their sharp outflow trends losing another $1.7 billion in the week ending September 18th, an improvement from last week's $2.7 billion outflow but none-the-less the 11th consecutive week over the $1.5 billion outflow mark. Franklin Resources (BEN) continues to have the most exposure in our coverage group to declining Municipal bond trends with over 10% of its assets-under-management in the tax-free category. The 2013 weekly average for fixed income fund flow has now drastically declined from 2012, now averaging a $521 million weekly outflow this year, a far cry from the $5.8 billion weekly inflow averaged last year.

Hybrid funds, or products that combine both fixed income and equity allocation, continue to be the most stable category bringing in another $1.5 billion in the most recent weekly period, an improvement from the $1.2 billion inflow the week prior. The year-to-date weekly average inflow for hybrid products is now $1.6 billion for '13, almost a 100% increase from 2012's $911 million weekly average.

Passive Products - Largest Weekly Equity ETF Inflow In Our Dataset:

Exchange traded funds experienced wildly positive trends on the equity side and mildly positive trends in fixed income for the week ending September 18th. Equity ETFs gained $25.8 billion, the biggest weekly inflow in our data set with balanced inflow into international, sector focused, and large-cap products. Including this week's inflow, 2013 weekly average equity ETF trends are averaging a $3.4 billion weekly inflow, an improvement from last year's $2.2 billion weekly inflow average.

Bond ETFs also had a mildly positive week with an $850 million inflow, which was a slight decline from last week's $1.4 billion subscription. Including this sequential drop in the most recent period, the 2013 weekly bond ETF average is now just a $388 million inflow for bond ETFs, much lower than the $1.0 billion average weekly inflow from 2012.

HEDGEYE Asset Management Thought of the Week: The Market is Tapering the Long End Itself:

While the U.S. central bank continues to peg its bond buying programs to backward looking forecasts, the bond market continues to taper the long end of the curve itself and has pushed the 10 year Treasury yield up from a low of 1.6% in May to its current level of 2.6% this week. Hedgeye's Macro Team has introduced the thought that the continued accelerating improvement in year-over-year weekly jobless claims will eventually be reflected in the monthly Non Farm Payroll (NFP) numbers (despite different bias' in these data-sets) and that next week's NFP print for September on Friday, October 4th may finally prove out a closer relationship between these two employment variables. Thus, the 10 year Treasury yield may again spike up to recent highs on renewed Fed tapering expectations. In the event of a back up in 10 year rates again, we continue to observe the correlation between 10 year Treasury yields and Franklin Resources (BEN) stock which has strengthened over recent weeks. This investment manager with a large exposure to Municipal bond trends and Global Bond flows has been trading on the trajectory of long term yields under the thought that as bonds sell off, the fixed income and retail nature of BEN's assets-under-management levels will be negatively impacted. When we first spotted this developing correlation, the R-squared between BEN and the US10YR was 0.32. The R-squared currently is 0.50 and continues to bear watching especially if U.S. macro economic data continues to improve.

Jonathan Casteleyn, CFA, CMT

Joshua Steiner, CFA

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09/26/13 11:41 AM EDT

The SEC Tweets – Caveat Emptor

The Jumpstart Our Business Startups (JOBS) Act took effect this week and the SECtweeted an Investor Alert focused on the lifting of the ban on advertising and “general solicitation” on qualifying private placements. This provision has been the focus of criticism from the likes of former SEC chairman Arthur Levitt – a staunch and effective proponent of investor protection – and professor William Black, a financial crime expert who was responsible for uncovering Congressional fraud in the Savings & Loan scandal.

The JOBS Act is intended to make it easier for small start-up businesses to raise money, especially using private placements. Flexibility afforded by the Act includes exemption from requirements of SEC registration for qualifying companies, including exemption from making certain required regulatory disclosures in connection with an IPO, and a longer five year phase-in of the already reduced small-company requirements of Sarbanes Oxley (those pesky rules Congress introduced to prevent the massive accounting fraud that sunk companies like Enron and WorldCom). The JOBS Act also increases both the number of shareholders and the amount of capital that can be raised privately, giving start-up companies a longer runway before they have to register with the SEC.

What Could Go Wrong?

The SEC Alert highlights certain risks of investing in private placements, including the possible loss of your entire investment – a pretty common outcome with smaller private offerings – and the lack of a liquid market, which means you may have to hold your investment forever – another common result. Remember that a private placement by definition does not trade, meaning you can’t get your money out at all until there is an IPO. The reduced filing obligations under the Act mean companies will provide less information. The Commission says “companies have more discretion in what information to disclose to you” and emphasizes “Pay particular attention to any risk factors that are described,” with the very strong implication that companies can get away with sweeping stuff under the carpet, and that therefore any risks they feel compelled to disclose must be really risky.

Isn’t there any protection left to the individual investor? you ask. Well, in order to take your money, the company still has to verify that you are an Accredited Investor.

Should I Feel Better Now?

Regulation D, which governs private placements, identifies certain investors as “Accredited,” meaning they are deemed both sufficiently sophisticated, and financially suitable to assume the risks of a private placement investment. The list includes banks, insurance companies, mutual funds, registered investment advisers… and individuals with $200K in annual income ($300K jointly with spouse) or $1 million in net worth. This financial standard was introduced in 1982. Since then, lots of things have changed – but the financial test for Accredited Investor has not.

You don’t have to have a PhD in economics to reckon that a million dollars in 1982 is different from a million dollars today. Thankfully, the value of your primary residence is excluded from the calculation, but other stuff is included – like your 401(K) and your IRA accounts – meaning that “net worth” is not at all the same as “cash.” In other words, you could be Accredited, be a millionaire, and still have a hard time making your mortgage and tuition payments.

Just for a lark, we ran $1 million 1982 dollars through the CPI Inflation Calculator on the Bureau of Labor Statistics website, which says that the 2013 equivalent is $2,423,595.85. This means that even under the old Reg D restrictions the number of Accrediteds has grown tremendously. Accrediteds now represent a higher percentage of the general population but they are a lot less rich than when the standard was introduced. Being a millionaire just ain’t what it used to be, a reality that everyone gets except Congress and the government agency charged with protecting the investing public.

Are you worried yet?

While easing the path to investment capital sounds positive and pro-growth and overall beneficial to America, direct-to-investor advertising is not an unmitigated societal good. It makes us think of direct-to-consumer marketing of pharmaceuticals – outlawed in every country but New Zealand and the US – which is often viewed as an end run around regulation, designed to make people clamor for new drugs they may not need, or for off-label uses of existing drugs.

In the age of Facebook and Twitter, direct solicitation is inevitable, so it is legitimate to view the JOBS Act as Congress trying to get in front of an unstoppable event and to start making regulations around it. But one of the Act’s most important and up-to-date objectives has so far gone nowhere; open crowdfunding of start-ups was supposed to be implemented by the end of last year. The SEC hasn’t even begun drafting rules covering crowdfunding, perhaps waiting to first view the carnage from Open Season on retail investors. A lot of firms invested in crowdfunding technology, and many have shifted to launch their own private placement platforms – sort of “speed dating for retail investors” – in order not to lose out completely on their investment.

Unstoppable?

There was massive press hype in the lead-up to the Facebook IPO. So much so that Goldman Sachs, Facebook’s bankers, withdrew lucrative private tranches it had just offered to its partners and to key investors. Goldman was concerned that the SEC would construe all the media attention as “constructive advertising” and charge Goldman under Reg D. After the fact, the SEC said they would not have gone after Goldman over the final private pieces of the Facebook offering – but there is no way of actually knowing what the Commission might have done. The Act now makes it moot. You are now really, truly, and completely on your own. It’s a no-brainer to predict that the initial stages of advertising and marketing private placements directly to investors will see substantial damage to individuals’ net worths before the dust settles. We urge you not to be counted among the fallen.

Of Things To come…

One bright point in all this is our fantasy of what mass advertising for high-risk private placements will look like. We imagine a television commercial with scantily-clad women swooning over a supremely confident guy in an expensive sportscar. “What sort of man buys private placements?” asks the announcer. One look tells you all you need to know. The 30-second spot will leave you panting for the kind of success that only private placements offer. “Chernham & Burnham Private Bankers, Ltd.,” croons the announcer. “Let us handle your privates.”

Looks like Wall Street is going to be fun again after all. Watch yourselves.

PNRA: NO QUICK-FIX RECIPE

PNRA remains on the Hedgeye Best Ideas list as a short.

The street currently expects the trends and issues Panera faced in 2Q13 to disappear by 4Q13, but we view this as highly unlikely. There is no quick-fix to these issues and we believe they will persist for a while. We address these issues below and highlight where our views differ from consensus.

SECULAR ISSUES

More Fast Casual Options – NPD recently reported in its CREST industry tracking service that, for the 12 months ended in May, visits to fast casual restaurants grew +9% year-over-year and the number of fast casual units grew +7%. While it is unlikely that all the new units are those of direct competitors, this increase will hurt traffic trends on the margin as consumers have more options.

Not The Only Healthy Competition – Not only is Panera seeing more competition in the fast casual space, but also from QSR chains that are upgrading their menus. This, on the margin, is negative for Panera. These menu upgrades include items that are being competitively marketed as healthy eating options and are cheaper than PNRA’s core offerings, making them very attractive to consumers.

No Pricing Power – With an average check in the $9-$10 range, PNRA has created a pricing umbrella for non-traditional competitors to take advantage of in order to capture incremental market share. We have seen this begin to play out, as a number of casual dining chains are now offering lower price points at lunch, typically in the $6-$7 range.

SELF-INFLICTED ISSUES

Operational – The company has publicly admitted to having a number of widespread operational issues, ranging from a lack of kitchen equipment to a lack of seating. Capacity issues have dampened lunch time transactions and management has struggled to drive peak hour throughput. Therefore, we believe the labor line favorability the company has seen lately will wane, as PNRA will have to invest increased labor in some of its cafes in 2H13. Our view, in this regard, is not widely shared. The consensus expectation is for labor costs to be flat as a percentage of sales in 4Q13, a feat that we view as very unlikely.

Panera’s Traffic Problem – We believe PNRA has been too aggressive in its pricing over the past five to six years. Panera’s pricing umbrella we referred to earlier has resulted in traffic declines for the past three quarters. While consensus is looking for a conservative -0.6% decline in 3Q13, a rebound to a +0.4% gain in 4Q13 is aggressive.

Still Loved By The Street – The aforementioned issues are manifesting themselves in the components of comparable sales growth, as PNRA traffic trends have been a point of weakness lately. At 9.8x EV/EBITDA, the stock currently trades at a discount to its QSR peer group trading at 14.x EV/EBITDA. We believe this discount is justified and expect PNRA to have another rough outing in 3Q13.

Howard Penney

Managing Director

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